Yesterday, the Dow Jones opened up nearly 130 points, then dropped over 400 in the next hour and a half before closing down by a mere 63 points. Two main variables are at play, namely quadruple witching and an unexpected robust August retail sales report. Overnight futures activity showed 100 point swings from positive to negative as well.
Let’s start with quad-witching. The third Friday of every quarter-end, contracts for stock index futures and options, and single stock futures and options all expire. Global stock markets have similar timelines as well. In short, investors need to cover their leveraged bets on the long or short side by closing out options and futures contracts. Stocks with heavily traded contracts show wild intraday movement, not dissimilar to the major averages’ action this week where 400 point moves occur within minutes. Historically, this volatility has led to weak stock action prior to expiration day, then a rally can resume. Consider it a washing out of weak stock holders but not after heavy hitters move markets in their favor before closing out contracts.
To add fuel to the fire yesterday, an August retail sales report posted a massive beat relative to consensus estimates. Back-to-school shopping was strong and child tax credit payments from the Government were spent (most low wage earners immediately use every nickel they get). Previously, slumping consumer confidence reports led many to believe spending might be subdued. However, that was more related to the Delta variant and did not slow online spending which was up 5.3% after dropping 4.6% in July. Fading stimulus was also expected to slow spending but consumer balance sheets are still flush and jobs are plentiful. If one wants money, they can certainly get it cheaply.
Further, vacations were cancelled, travel and entertainment venues were lackluster due to Covid. Those lost sales are gains for retailers, at least for now. However, all of those cargo ships stuck in the ocean caused a drop in electronics, autos and appliance purchases. These are typically recovered, hopefully sooner rather than later. All in all, it was a solid report presenting an uber-strong consumer. This has a side effect though.
Any report that pulls GDP higher, or wages higher, or consumer spending higher, or inflation higher (excessive consumer demand leads to pricing power) will pull forward tapering. In and of itself, that is not a problem. There is no reason for the Fed to be buying $40B in mortgage-backed bonds or $80B in Treasuries at this point in time. Our economy is on firm footing and bond purchases are not going to fix Covid-induced slowdowns in select industries. While retail stocks rose yesterday after the report, interest rates increased as well.
The real concern will arise as this puts the Fed one step closer to actually raising short-term interest rates. Most bull markets don’t die of old age. They come to a halt when Fed interventions create an inverted yield curve or too restrictive interest rate levels that make borrowing capital too costly.
There is no rhyme or reason to the start of this Fed rate hike cycle. It could come immediately after tapering or, it could come years after tapering ends like last time. Data dependency means next summer’s CPI, PPI, retail sales and unemployment reports are critical. Predicting that today is foolish, not to mention misplaced based on history, especially if one is selling stock today in anticipation of a prediction that rates are going up in 12 months. Almost every Fed rate hiking cycle starts with an immediate stock sell-off only to be resumed with rallies to new highs. Trying to time these situations is difficult for all and not recommended. Bull markets don’t end at the sight of one rate hike. In fact, any pullback associated with that reasoning has proven to be a good buying opportunity.
Rather, we know what happens during economic cycles and can glean some picture of what to expect. In early cycle recoveries, certain sectors do very well: small caps, banks, housing, lenders, energy and commodity stocks. Making money later in cycles becomes a bit more difficult. Rising tides lift all boats initially, and then cream rises to the top. Who is taking market share? What companies can survive higher lending costs? What new product lines are replacing legacy leaders? All of this points back to the rotational, transition phase Jim Meyer and I have been discussing for a few months now.
Rolling corrections are everywhere. Transportation stocks are down 10% – 20% from their highs a few months ago. Ditto for smaller, regional banks. Commodity companies like Freeport-McMoran and US Steel are down 26% and 17%, respectively from their recent highs. Cyclical industrials like Caterpillar and Deere have declined 17% and 11% as well.
Pair those with SPAC’s which are well below offering prices; IPO’s like Coinbase (42% drop from highs), AirBnB (down 23%) or Covid winners like Zoom (down 53% from last year) and you are looking at a large swath of the market suffering badly. All while the major averages are only 2% -3% off recent all-time highs. Being in the right names has proved immensely invaluable for 2021. A concern for many, and rightly so, is what happens when this rolling correction finally hits mega cap, FANGMAN stocks. If their earnings continue to outpace estimates at 2-4X GDP, it could be a while.
Football star, Patrick Mahomes, is 26 today. Narendra Modi, Prime Minister of India, turns 71.
James Vogt, 610-260-2214